Re: causes of stock market contraction

[larson@xxxxxx (S R Larsson)]

Nat Riley:
>        The reporter states quite erroneously based on my skimpy knowledge
>that --
>"The only way to get out of a deflationary period is to contract the supply of
>goods.  This means shutting plants, laying off workers -- anything that will
>remove excess supply from the economy and restore companies ability to raise
>prices of their goods."

S Larsson:
That's the medicine always suggested by mainstream-educated economists. If
you want to speed up a deflationary process, then that's exactly what to
do, since it sends shockwaves of negative expectations through the economy.
Where would the Japanese economy be today if they had tried that? They've
been fighting strenuously for a couple of years now to stay out of the
deflation trap. Their fiscal have done little in positive, but we have good
reasons to believe they would have been much worse off without them.

It is also true that once a deflation process comes into motion it is quite
hard to stop. It is the combination of deflation in asset values and
consumer prices that is the most dangerous in modern economies, where a
considerable part of consumption depends upon inflation in the stock
market, real estate etc. The crucial question now is perhaps not how
households react, however, but how businesses respond: when their regular
production divisions meet deflation in the product market AND their
financial divisions meet deflation in the stock market - how do corporate
executives respond? They cannot boost their results by financial
speculation, and they cannot produce good sales revenue prognoses. It's
hard to see that they would panic, closing production facilities by the
numbers. If they are clever they endure the storm by defending their market
shares and sending what they've got left into the stock market - once the
Asian cold is over it's time for a new rally, probably as long as the
current one. After all, we all know that the stock market is capable of
producing 20% return per annum - where else would we go?

This would mean that deflation in the stock market would end quite soon.
Once a negative trend there comes to an end, demand on product markets will
pick up again and CPI deflation will come to an end. The length of this
process is the tricky thing to figure out, though. A downturn could last
for a couple of years, but if Europe comes through the first phase of the
common currency process I think the negative pressure over here would ease.
That would boost demand and set financial markets back on track again. This
would mean a restart for the economies in Europe by early '99.
Proliferation on the financial market should then be quick, so the US
economy could get its wheels going again quite soon after. The bad scenario
is if Europe stumbles and falls on its way towards the common currency (as
I've said before it may very well do). Then we're in to a recession that
could last for a couple of years.

The overall impression so far is that the recession is not going to be so
severe. Asia is downsizing, America is putting Wall Street on a controlled
diet to lose some weight and for the time being everything is relatively
calm in Europe. International investors are resetting their major portfolio
weights, but once that is done we will see a period of stability GIVEN
Europe does not suffer from currency raids connected to the pending euro
process.

Got it? (Everyone prospering thanks to the above forecast is free to send
3% of all gains to my secret bank account in Lichtenstein...)


/srl

-----
Sven Robert Larsson
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